The board's importance in attracting your investment

If we are not going to abolish company boards and if we accept that boards are relevant, then shareholders have a duty - not just to themselves - but to the organisation and the whole economy to get the right people in the right place doing the right job.

If the contrary position continues where boards are unfocused and skills and aptitude are not matched to opportunity, returns will continue to decline over time to the cost of all owners and to society. Management and boards, who are accountable to no one, naturally over time become motivated by self or just get lazy.

Boards self perpetuate. Boards select replacements for themselves, shareholders rubber stamp the process after the event. Good boards should pick good replacements, bad boards bad, like seems to beget like, and birds of a feature do flock together.

Why do shareholders rubber stamp boards? Simple really, most don't care. Go back and re read the series on portfolio theory. More to the point board members who on the face of it have a public profile, are actually fairly private and it is impossible for shareholders to get to know the people they are voting for. The only opportunity to even get a chance of doing so is the annual meeting, and for most shareholders it is impossible to attend such meetings.

Thus they never have an opportunity to interface with boards or chairmen to actually assess their skills, integrity or anything else. Thus voting on board replacements is actually a blind vote and probably in such a situation it is better to leave it to those who do know to vote, or just accept that the board knows what they are doing.

The problem with leaving it to those who do know how to vote on such matters is that often those who vote have an agenda. EG sack the board, do a new deal, buy out my private company, skim the tin etc, Take for example a widely held company with 1000 shares. One shareholder has 50 shares and a vested interest, and the next biggest holder has 10 shares. If all the people who hold 1 share each do not vote, 5% of the company will decide the future of all.

Thus when I am investing, after of course having decided that the company seems cheap, the first next test is who the major shareholder is. What do I know about them, are they gamers, will they play with this company? Because the reality of modern capitalism is that they can due to the inertia of the masses. The second question is who is the chairman? If I don't know him already I will try to meet him. Who is the CEO, likewise.

The rest of the board I don't care about unless it has an obvious prick on it and if any of these people do not in my view have integrity and a reasonable track record, even cheap companies I will pass by.

By the way I have not made a new investment in an NZX listed company over the last year because the well governed companies are not cheap and the poorly governed ones are not worth buying. So if you are in any doubt that governance doesn't pay there is the evidence.

This empowerment of a few with agendas is seen by a growing number of economic thinkers as a dangerous dead weight economic effect.

For example around 7 years ago a UK think tank proposed punishing shareholders who did not vote, one suggestion was that any share that did not vote would be tagged and their dividends would be blocked and reallocated to those who did vote. Nice in theory.

But this would just reward the few who have an agenda more in the short term and after the first year every shareholder would send the proxy forms in with random ticks and it would just become a lottery and nothing would be fixed. What is needed is intelligent engagement.

There is a precedent that could be used to fix this in a meaningful way, and it was invented by boards and management themselves.

In a previous blog on sundry other voting annoyances I outlines the structure of American Depository receipts (ADRs).

To reiterate, ADRs are a structure used by companies to bundle up a block of shares to list them on a US exchange. For example 100 million shares in Telecom might be placed in such a bundle and 1m ADRs are then issued, so each ADR has voting rights over 100 shares.

This is a structure whereby the company enters into a contract with a trustee (the depository of the 100m shares) and the terms of that contract are binding on the trustee and on all the holders of the ADRs, i.e. shareholders. The contract is of course written by the board or management and the terms can be whatever the board wants. Guess what? In the fine print in these contracts is a clause that says if any ADR holder doesn't vote, the unvoted shares can be voted by the board.

Now sure I have challenged these regimes vigorously over the past few years and I doubt that a single board would now ever use such unvoted shares in any vote. That's because the conflicts of interest are so obvious that even after three head buttings one board eventually got it and I guess the rest would now have followed.

But out of this completely repugnant regime an idea for ensuring that boards are held to account and thus driven to perform is obvious.

Maybe NZX should set up an independent body of non-conflicted parties who have knowledge of the market place and the people in control. This could also change the listing rules to provide that every listed company must have a constitution that specifies that any shareholder who does not vote their shares gives this body an undirected proxy to vote as it sees fit.

The only problem with this is that likely in widely held companies this would give this body total control. Thus its composition and the appointment regime for these people would be very important. If NZX controlled that it would present a conflict of interest for many reasons not the least of which is the fact that it is itself a listed company.

In any event why re-create the wheel, such a body already exits. It is the Shareholders' Association or maybe even the Cullen Fund. So all we have to do is change the listing rules to define the Shareholders' Association or the Cullen Fund as the undirected proxy for all shareholders who do not vote.

I think that is a wonderful idea, but then I would wouldn't I.

If the NZ public were given the choice between the government taking over the voting rights of all unvoted shares or the Shareholders' Association I think it would be an interesting call, wouldn't it? And I guess it wouldn't matter either way, as if such enormous power was abused shareholders would call an extraordinary general meeting and vote their own shares and fix the problem? Yeah right, the brake on the abuse of this power is the problem the structure is designed to fix.

So who would you want to trust with this power, me and the Shareholders' Association, Adrian Orr and/or the government or the boards of the companies themselves? The default is the last one and the last 40 years have shown that this is not working. Returns on equity have been declining. Market returns have been ok. Why is that $1 of income 40 years ago in equities would have been worth $8. Now 60c of income is worth $12, and we have fooled ourselves into thinking all is good.

But again this will not happen as it requires someone other than you or I to do something. The last blog in this series is a blog on what you can practically do to change the world and what the Shareholders' Association will do next year if I have my way, which these days often I don't.